The gap between market expectations of sovereign debt restructurings and official non-discussion of institutional arrangements for restructuring is wide.
While markets are pricing a substantial default risk for Greek, Irish, Portuguese and even Spanish bonds, the financial policy debate is squarely focused on the causes of the last crisis. Arrangements for dealing with the likely next crisis—sovereign debt restructuring—are not in the public debate.
The just-published yearly report of the Principles Consultative Group (PCG), charged since 2004 with overseeing such arrangements as exist, delivered an ominously complacent message—all fine on this front. The costs of this head-in-the-sand behavior are, first, that approaches to sovereign debt problems are skewed toward bail-outs and, second, that precautions against messy restructurings are not being considered.
The basics on this contentious issue
In 2003 the IMF pushed a proposal for a Sovereign Debt Restructuring Mechanism (SDRM) into the debate on global financial architecture. The aim was to create an orderly process for emerging market (EM) debt restructuring addressing two key hazards: hold-out creditors and inadequate funding during restructuring. The proposal met opposition from creditors (fearful of constraints on their room for maneuver) and debtors (fearful of appearing soft on restructuring). The proposal was dropped and three compromises accepted: 1) greater use of Collective Action Clauses (CACs) in bond issues (these mandate that a qualified majority of bond-holders can change terms of a bond issue); 2) reaffirmation of IMF lending into arrears; and 3) agreement on voluntary principles for creditor/debtor behavior to avoid debt build-ups and guide restructurings.
The use of CACs has expanded since 2004, though data on how much are imprecise. As sovereign debt crises have been scarce since 2004, the Principles, overseen by the Institute of International Finance (IIF), a consortium of private banks, are largely untested in actual restructurings.
The SDRM debate and ultimately the Principles were focused on sovereign EM debt. This made sense because sovereign debt problems were almost exclusively the provenance of EMs: not only were they the heavy debtors, but also they, unlike advanced countries, often issue debt under the law of other countries (with large debt markets) so restructuring presents distinctive legal issues.
Fast forward to 2010. Helped by a historically large bail-out sponsored by the IMF and EU, Greece narrowly escaped a restructuring or potentially messy default. Asset prices suggest that markets still expect restructuring in Greece and even several peripheral but advanced European countries. In effect, markets are begging for attention to how restructurings would be framed and executed, not as tradition would have it, for EMs, but for rich countries. The pitfalls in advanced countries (who issue debt under domestic law) are somewhat different from those in EMs.
What Should be Happening?
The 2003 debate on international architecture for restructurings revealed the extraordinarily difficult issues involved. Though the compromise solution represented progress, especially the expanded use of CACs, it left large gaps. With the prospect of sovereign debt restructurings in advanced countries, several issues need urgently to be addressed.
1) Establishing some notion of limits on access to IMF financing. The Greek rescue arrangement reiterated a longstanding truism: in the heat of the moment, the short-term costs of a bail-out are almost always seen as lower than those of a restructuring, even if it is orderly. Thus, the size of IMF financing packages ratchets up from crisis to crisis leaving creditors with no clear indication of limits.
2) Consideration of restructuring arrangements not just for emerging markets, but also for advanced countries must be revived. Available information indicates that most Greek bonds do not have CACs. Granted, most Greek debt is issued under Greek law so a restructuring could be achieved through a (binding) Parliamentary revision of Greek law. But such an approach would be highly disruptive in comparison to creditor committee agreement to exchange offers. The focus of the Principles on EMs (recently extended to low income countries) is anachronistic given that sovereign debt problems are now most acute in advanced countries.
3) The adequacy of CACs needs reconsideration. First, how prevalent are CACs, and is their potential importance in advanced country issues recognized. Second, CACs in general apply to single issuances. The attraction of the SDRM was that it proposed single creditor committees that could bind decisions across holders of multiple issuances. Hold-out groups of bondholders driven by uncertainty about decisions of other bond issue groups could remain a risk.
Where can these issues be addressed?
This year’s PCG report took the commendable step of extending the Principles to situations where a government sets important parameters affecting a restructuring institution (banks in Iceland, for example). But it was silent on Europe’s sovereign debt problems and, by extension, how the Principles would apply to an advanced country rescheduling. In fact, it did not even extend its annual assessment of data transparency to advanced countries.
European governments have their own interests in avoiding consideration of a framework for restructuring in Europe.
This leaves the IMF, where attitudes reflect a recent Staff Position Note entitled “Default in Today’s Advanced Economies: Unnecessary, Undesirable, Unlikely." Perhaps. The paper includes many valid points. But the stakes are too high not to be prepared for restructuring. The IMF must start the discussion of institutional arrangements for restructuring in advanced countries as insurance against yet another failure to anticipate sources of market chaos.
Susan Schadler is a non-resident Senior Fellow with the Atlantic Council and formerly Deputy Director of the IMF’s European Department.
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